Main source: NS ch 8
What makes sense?
We should set the price that maximises our revenue
We are at the point where if we raise our price by 10% sales will fall by 5%, so we better not do it!
???
We reduced our price to £1000 this year and we were able to sell 10 units more this year than last year. These only cost us £500 to make, so we are better off.
???
We should stop producing immediately, because the market price has fallen below our average costs, if we take into account our yearly license fee
???
Context
Production functions, prices \(\rightarrow\) cost of production …
Now: “what output to set to max profits?”
Next: consequences for the market
Q: Impact of increasing quantity?
MR \(<\) market price here because
Get (new) market price for additional unit \(\rightarrow\) + 0.99
But lose 0.01 on all previous 50 units \(\rightarrow\) - 0.50
So MR is 0.49
MR curves be like:
A price-taking firm (perfect competition):
Thus its marginal revenue is constant at \(P\)
…if this exists
For a firm with market power:
Price-taking firms: what price?
Can sell all output at market price P. Will price at P.
Set P<P* \(\rightarrow\)?
Set P>P*?
Price-taking firms: How much to produce?
(Draw)
But…
But if P* below your average cost for any possible output q \(\rightarrow\) shut down!
If P* below ‘(SR) average variable costs’ \(\rightarrow\) shut down immediately.
If P* \(<\) LRAC \(\rightarrow\) shut down before incurring further FC.
From 2017 final exam
A firm that sought to maximize revenue (rather than profit) would choose to produce an output level for which marginal revenue was equal to
Choose all that apply: If the demand faced by a firm is elastic (but not perfectly elastic), selling one less unit of output will
How firms’ supply curves aggregate to the market supply curve
What is a ‘perfectly competitive market’?
Motivating questions:
Importance of entry /& exit, implications for short & long run:
LR market supply curve: what it looks like & why
…
Basic argument: why perfectly competitive market \(\rightarrow\) Pareto Optimal outcome (under certain conditions)
Critiques of this, idea of ‘market failure’
Consider: Should price-taking firms and perfect competition be our ‘baseline’ dominant model?
Reasonable to assume?
Free entry of firms/no ‘barriers’?
Homogenous products?
Decreasing returns to scale at some point?
Deep political/philosophical question:
Should we expect ‘chaotic competition’ to lead to the most efficient outcomes, and if so, when and under what conditions?
Better to restrict the entry of firms (single firm with a guaranteed monopoly?)
Better to regulate prices?
Urgent question: Brexit
Trade with Europe may default to WTO terms
\(\rightarrow\) Very large tariffs on some goods, ‘non-tariff barriers’ on others
UK (and EU) firms: Unknown impact on input prices, demand curves, competition, etc.
Can ‘GE models’ help predict these and help firms plan and reoptimise?
How long will it take to return to some ‘equilibrium’?
Also, … many new regulations bundled with new trade deals:
For a further revision, ‘firms in competitive markets’ is well mapped out in a step-by step Powerpoint you can download:
http://web.mnstate.edu/stutes/notes/mankiwjustpp/firms_competitive.ppt
(start from beginning, this is specifically referred to beginning on slide 17; use ‘presentation mode’)
We will quickly outline:
SR: Number of firms in the market is fixed: no entry/exit
Recall: Under perfect competition each firm
charges market price \(P^*\)
produces q at a point where \(mc(q)=p^*\)
Thus, for every price \(P^{*}\), it produces \(q\) where \(mc(q)=P^{*}\).
\(\rightarrow\) its mc curve is its supply curve!
Except where \(AC(q)>p^*\) for all q \(\rightarrow\) it produces zero
Sum each firm’s supply curve horizontally
(Read at home: handout, text)
Sum across firms (mc curve where \(>\) AC curves) \(\rightarrow\) market supply curve
Sum individual demand curves \(\rightarrow\) market demand curve
Where do these intersect?
\(P^* > AC\) possible in the short run
\(\rightarrow\) can make SR economic profits!
Avoid confusion: The market demand curve is downward sloping. The demand curve for an individual firm under perfect competition is effectively horizontal.
In LR ‘free entry and exit’ of firms, many firms have access to same production process
Suppose positive economic profits in industry (for efficient producers)
I.e., \(P^*>AC(q)\) for some q
\(\rightarrow\) Firms enter \(\rightarrow\) Supply curve shifts out
\(\rightarrow\) equilibrium price declines \(\rightarrow\) profits decline
Repeat until economic profit falls to zero, i.e., until \(P^*=AC(q)\) for the minimum AC q
Now suppose negative economic profits in industry (for efficient producers)
\(\rightarrow\) Firms exit \(\rightarrow\) Supply curve shifts inwards
\(\rightarrow\) equilibrium price rises \(\rightarrow\) profits rise
Repeat until economic profit rises to zero; i.e., until \(P^*=AC(q)\) for the minimum AC q
Long Run Equilibrium
Firms choose output to max profit
Profit max: \(P^* = MC(q)\)
No firms in the market want to exit, no firms outside want to enter
Zero economic profits:
\(P^* = AC(q)\)
Also, with free entry/exit…
all firms (in) produce \(q\) that minimizes their AC, and all same average cost
I.e., \(P^\ast = min[AC(q)] = MC(q)\) for any firm in the market
I.e., MC curve intersects AC curve at its minimum.
Why?
Why \(P* = min [ac(q)] = mc(q)\)?
No profit in equilibrium and firms choose q so that \(P^\ast=mc(q)\)
\(\rightarrow\) \(P^\ast = AC(q) = MC(q)\) for all firms (in the market)
Suppose a firm produced at a point above it’s minimum AC,
\(\rightarrow\) it could profit by producing at the q that minimised its AC (contradicting above)
2019: This curve itself is not covered on the midterm, so we may skip it for now
We have the SR supply curve (upward sloping)
But we know that in the LR this will shift out in response to a price change
\(\rightarrow\) Taking this shift into account gives us the Long Run Supply Curve
LR supply curve looks like?
Demand curve shifts out \(\rightarrow\) price rise \(\rightarrow\) firms enter
… do firms produce at the same minimum AC as before?
Depends:
Long run population and economic growth \(\rightarrow\) ?
As the economy grows, which items will get relatively more expensive?
Long-run elasticity of supply: % change in LR \(Q^s\) / % change P
(Various estimates over the years, see NS text)
Extra value … from consuming good over its price. WTP for right to consume a good at its current price.
Value producers get for a good less the opportunity costs they incur by producing it. What producers would pay for right to sell good at current market price. (Essentially profits not counting FC.)
Roughly; single-market depiction
Total surplus \(=\) consumer \(+\) producer surplus
At market equilibrium: no more mutually-beneficial exchanges can be made
‘A competitive market in equilibrium will max total surplus’
We can use these models/concepts to consider…
‘Micro-quizes’
9.2, 9.3, 9.4,
‘Problems’:
9.3a and b
9.5?
9.9 a-d?
Under perfect competition, if an industry is characterized by positive economic profits in the short run
If the market for coconut water is characterized by a very elastic supply curve and a very inelastic demand curve, an outward shift in the supply curve would be reflected primarily in the form of
Under perfect competition, if an industry is characterized by positive economic profits in the short run
This is a very brief excerpt and summary of the material in NS chapter 10, with some additional motivation. If you understand these slides/notes you don’t have to read chapter 10.
Under certain conditions competitive markets are efficient in equilibrium
But:
General Equilibrium (GE) analysis: entire economy as a system of interacting, interdependent markets
GE: Set of prices s.t. \(Q_s(P)=Q_d(P)\) in all markets, including input markets
Overall Pareto efficiency: no one can be made better off without making someone else worse off
Why is this how we define efficiency?
Because if we could do so, we would not be at an efficient point
Overall efficiency requires three conditions:
Given society’s resources, we are producing ‘as much as possible’
Efficiency in production?
Efficiency in production?
Specifically, economy produces on the PPF: given available inputs, we produce ‘as much as possible’
\(\leftarrow\) Ensured by ‘efficient use of inputs’ (same ‘bang for the buck’ per input for all firms and products)
\(\leftarrow\) Ensured by ‘competitive market for inputs’ (all firms face the same prices, prices set to equalise demand and supply for inputs)
Given what we’re producing, it is going to the ‘right consumers’.
Does this look familiar? Where can you find it at Exeter? What does it mean?
Specifically: No way to reallocate output amongst consumers to make them all better off
With DMRS, this is equivalent to ‘for the last (positive) unit of X purchased by each consumer, they are all willing to give up the same amount of X to get another Y’
I.e., their marginal rates of substitution for the last unit they buy are all the same: equal to the price ratio.
\(\leftarrow\) basically ensured by the \(MRS(x,y)=p_x/p_y\) ‘bang for the buck’ condition.
Given our inputs, we can produce ‘efficiently’, i.e, along the PPF,
and given the amounts of each good produced, it is ‘consumed by the right people’ (no more room for trade) …
yet we may still not be at efficiency? Why not?
We need to produce the right combination of goods.
Efficiency \(\leftarrow\) (Along PPF), can’t adjust product mix to make any consumers better off without making some worse off
Formally:
DMRT on x PPF & DMRS for consumers (rem: all have same MRS) …
\(\leftrightarrow MRS(x,y)=MRT(x,y)\) is necessary/sufficient for top-level efficiency
I.e., marginal tradeoff in production = marginal tradeoff in consumption, i.e., Slope of PPF at chosen point = slope of everyone’s indifference curve at their chosen point
Need \[MRS(x,y)=MRT(x,y)\] for top-level efficiency.
Why should the free-market lead to this?
Optimizing consumers, free exchange \(\rightarrow\) MRS reflects relative prices
competitive firms choose q’s s.t. \(mc(q_x)=p_x\) \(\forall\) firms, goods
\(\rightarrow\) ratios are equal; consumers’ value tradeoff equals production tradeoff :)
So if we could costlessly redistribute endowments, we could attain any socially-desirable outcome by doing so, and then relying on the free market.
But these assumptions may not hold \(\rightarrow\) ‘market failures’
Markets not competitive, because of barriers to entry or increasing returns to scale
\(\rightarrow\) Prices won’t reflect marginal costs \(\rightarrow\) ‘deadweight losses’
Assumptions: ‘anything someone values’ is bought & sold in the market on their own behalf
But:
Externalities: All costs (& benefits) may not be priced; e.g., pollution
Public goods (and bads): Many benefit from the same good (e.g., fireworks)
Second Welfare theorem
If we could costlessly redistribute endowments, we could attain any socially-desirable outcome
by redistributing and then relying on the free market
But:
Redistribution via ‘optimal lump-sum’ taxes isn’t easy, as endowments may be unobservable
and redistribution based on things you can affect, e.g. income, may distort incentives.
Choose one or all that are correct. The following situation(s) or condition(s) imply the economy has NOT attained a Pareto efficient outcome.
A. We can produce more toothbrushes w/o producing less toothpaste, but this requires us to produce less food; all 3 goods are valued by consumers.
B. The economy is not producing any liverwurst; however, liverwurst does not enter into any consumer’s utility function.
C. At the current levels of consumption, older people are willing to give up 2 toothbrushes for 1 toothpaste, while younger people are willing to trade these off 1-for-1; both groups have a positive amount of each.
D. At current production, the PPF implies we could produce one fewer tube of toothpaste and thus produce two more toothbrushes; however, all consumers have a MRS of 1 between these two goods, and are consuming a positive amount of both.
Definitions of ‘types of goods’ as implied by characteristics of the demand function
Impacts of price changes (own good, other good) and income on an individual’s consumption, and what goes into this and how to depict it.
(Producer and) consumer surplus.
Firm’s conditions for optimisation in input choice.
Firm’s conditions for ‘what quantity to choose’ under different market conditions (price-taking, non-price-taking)
When it yields a Pareto-efficient outcome,
very basically what the first and second welfare theorems mean.
Goals of this introduction
How do economists define a public good? What fits into this category?
Better understand ‘market failures’
… Occur when prices don’t fully reflect the marginal social benefits or costs
May provide scope for political intervention
How does this happen?
What are the characteristics of a public good?
Def – A Pure Public Good is a good that is both
The fact that some people use the good doesn’t prevent others from using the same good.
There is no ‘crowding.’
Provision/consumption to additional users at zero marginal (social) cost.
Excludable and rival (depleatable)? \(\rightarrow\) Private good
‘Club goods’: excludable but non-rivalrous (at least up to a congestion point).
“Common property”: Nonexcludable but rivalrous
‘Somewhat’ nonexcludable and/or ‘somewhat’ nonrival: $ ightarrow$ ‘impure public goods.’
What about?
What about?
The basic ideas
If a good is non-rival then additional provision (of the units produced, to more consumers) is costless.
Thus,
And…
(If non-rival)
Even if each person provided it for their own benefit (on the assumption that no one else would), they would typically choose too little from a social POV…
Considering their own marginal benefits (and MRS) versus the price or cost, not the social marginal benefit (an ‘externality’ to them)
If a good is non-excludable it will be difficult to charge people for it
But if firms cannot charge for its full value, they might not pay the fixed costs to develop/build/provide it
Who would pay to produce a film that is freely pirated/distributed? Who would pay to develop a drug that must be priced at its marginal cost? Why contribute to police protection for your village, if your neighbours will pay for it anyways?
Policy: ‘Public goods argument’ - justifies many government programmes (military, environmental cleanup, research, etc)
Management: Companies/individuals can only profit (or even cover costs) from providing a public good through ???
…gaining subsidies, helping others avoid enforcement (fines) or ???
gaining voluntary support … or ??
by turning it into a private (or excludable) good.